Guest Interview:

Cheswick Investment Co Inc.

131 Rowayton Avenue
Rowayton,CT 06853

Interview Quarter: 3Q1998

Richard R. Cheswick

President

Q: Richard, you have more than 48 years of investment experience. How has your investing style changed since you began your career?

A: I started in Wall Street in 1950. The Dow Jones was around 160, and long Treasury Bonds were yielding 2.5%. Brokerage firms rarely ever published any research reports. Institutions really did not own any common stock of significance, and I remember pension funds that absolutely refused to take the risk of even owning 5% or 10% stock positions. The stock market was selling at about eight times earnings, and everyone was still fearing the widely forecast post-World War II depression. Investing was done very conservatively, and at the institutions where I learned my trade, accounts were typically looked at only once or twice a year. Stocks were yielding significantly more than bonds with stocks like American Telephone yielding 6% and General Motors yielding 8%.

I soon learned that most of the success in investing was coming from three or four stocks in a portfolio of perhaps 25, and it increasingly became clear to me that investing in a cross section of American industry was not necessarily successful. Many industries had very unattractive outlooks. I quickly came to the conclusion that one should only invest in the very best issues of companies that could grow reliably at a significant rate.

I still believe in that conclusion today and have used it successfully for 48 years.

Q: Your strategy is to hold domestic stocks for the long-term. Why only domestic stocks, and why do you prefer to invest long-term?

A: There has been no reason, in my experience, to own foreign stocks where the risk of currency fluctuation, political change and other possibly traumatic changes cannot be readily predicted. We invest in companies that participate in overseas markets and which have close oversight by institutions such as the Federal Reserve, SEC, FASB and NYSE.

Major profits are made through the magic of compounding growth. Compounding growth implies that one is a long-term investor. If a company averages 15% of growth per year, it will double its earnings in five years, quadruple them in ten years, octuple them in 15 years and achieve 16-fold growth in 20 years. On average, the price of the stocks will follow a pattern similar to that if one can find and retain stocks of companies that have this type of growth. They are out there. I have seen clients’ accounts rise 30 to 40-fold over my career! No other investment approach has made such a dramatic return on a reliable basis. The failure to follow this practice is the chief reason why most investment managers, whether professional or amateur, have such a poor record. Most seek to have a good quarter every quarter and a good result every month or week. Warren Buffett has said that you should only buy a stock when you are prepared to have the Stock Exchange close for five years after the day of your purchase. I would not like that, but I think he is clearly using the same long-term approach, and it is absolutely necessary to achieve large gains without gambling.

Q: How do you go about choosing stocks? Do you take the top-down approach of assessing investments from a general standpoint and working towards specific investments, or do you buy companies strictly on the merits?

A: We employ a top-down approach to assess investments. However, we also use a careful study of the background climate to determine the direction of our strategy. There are some areas that clearly have long-term growth records and promise to continue trends of this scope for years to come. A good example is the pharmaceutical industry where I have been investing since 1950. Stocks such as Pfizer, Merck and Johnson and Johnson purchased in 1950 have a cost of about 20 cents per share today after the splits have been counted. Even as recently as 1987, these issues were selling at only about 10% - 20% of the current price.

Q: You invest in core industries. How do you choose core industries?

A: We don’t think of ourselves as investing in core industries in the sense that we do not buy automobiles or steel or oil or chemicals or paper. We buy companies that have a long-term growth record, and we do make changes periodically on a thematic basis in order to shift with the times. In the late 1970’s we had huge oil positions; in the early 80’s we emphasized disinflation stocks; and by 1991 we were investing in technology stocks. Believe it or not, buggy whip, television and bowling equipment companies were once growth industries.

Q: Which core industries have looked attractive in the past, and how have they worked our for you?

A: There have been times to buy industries other than what we presently hold. Our current investments are chiefly in four sectors: medical, technology, consumer, and financial industries. In the past we have been in other fields. For example, when oil prices rushed upward from $3 to near $40 a barrel, it was obvious that no other industry had the same kind of attraction as the petroleum industry. For several years we had massive commitments to stocks like Schlumberger and Standard Oil of Indiana, Halliburton and others. By 1981 it was necessary to cut back on these substantially. Our next theme was disinflation as it became clear that the huge inflation rates that had existed prior to 1981 and ‘82 were being reversed by the very nature of the forces at work. With interest rates at 20%, there was no incentive to borrow and there was every incentive to lend. Rates began to plunge. In September of 1981 when the Treasury sold a 20-year call protected bond at 15 ¾%, it was a certainty that this would be a good investment over the long term. However, if one could figure out the trend of interest rates, it was far more profitable to buy an obvious growth stock, such as Bristol Myers at the time rather than to accept a 50% gain in Treasury issue, as attractive as that may have seemed. Bristol Myers went on from an adjusted price of $4 to $40 in the next decade and is now around $100. The disinflation stocks that were attractive included Baby Bells, regional banks, tobacco, as well the general run of growth stocks of that period. We have had a great deal of success from all of these thematic shifts.

Q: You further concentrate your portfolios within those core industries. Could you describe your selection process for choosing companies in targeted core industries?

A: I don’t think it is necessary to use complex factors to explain our selection process for choosing companies in growth industries. The facts are that money is usually made not through the study of the nuts and bolts of an industry, but by the understanding of the fairly simple issues of how and why they are able to grow. America’s two mortgage companies, Freddie Mac and Fannie Mae, are good examples. Both are aided by government policy and have been able to grow for decades without cyclical decline or significant risks to their operations. We have owned them almost indefinitely.

Q: How do you maintain diversification and avoid over-concentrating your portfolios?

A: It is a fine question whether one has over-concentrated a portfolio. Diversification can be easily obtained by buying a Standard & Poors or Dow Jones Index. For many years, however, most American businesses were not growing, and it was necessary to avoid the great majority of companies. In the old days, manufacturing was about 70% of the economy. Today, manufacturing is about 30%, while 70% is comprised of services. In the 1950’s, 60’s and 70’s, it meant that a recession was a calamity in Detroit and Pittsburgh and not too damaging elsewhere. Now, we have a service economy where recessions are much less meaningful. Many investment accounts are run with excessive diversification, and we think that careful selection of four, five or six industries and careful surveillance of the best companies within those industries is far more likely to achieve outstanding results.

Further, one should not necessarily sell every time a stock achieves a substantial gain. Over and over I have seen investors selling IBM when it reached 3%, 4% or 5% of the portfolio, believing that they were being prudent. They were selling this and other stocks before they increased 20 times in the years beyond! We let the stocks roll onward and achieve higher percentages of the portfolio, and I believe that once the client’s account has tripled and more, he or she is quite comfortable with this kind of process. It does mean that we have to watch carefully for long-term risks and also to follow a prudent policy that keeps clients at ease.

Q: To me, conservative investing means low volatility with diversification. What does it mean to you, and how do you achieve it?

A: I challenge the volatility studies that are made by some firms. If a stock has been stable for a period of years, it does not necessarily guarantee or imply that it will remain stable. A good example to me is Avon Products that in 1972 had one of the lowest beta ratings that I can ever recall because the stock had done nothing but go up and never went down over a period of something like 20 years. Yet from 1972 to 1974, the stock fell about 85%. I have little confidence in volatility or beta studies. I have far more confidence in our ability to observe companies and to act accordingly.

I also take exception to risk-return assessments of investment managers. One manager is rated more highly than another even though his performance is lesser, because some research has suggested that he took more risk. I do not find that to be a compelling argument. We would also say that the typical high turnover rates make such studies much more questionable. The average turnover rate of growth equity mutual funds is over 80%, meaning that on average, mutual fund equity portfolios are completely revamped every 15 months. This cost of trading is a substantial negative. Capital gains taxes run at the rate of 40% on short-term issues and 20% on long-term holdings. Additionally, there are transaction costs of significance. For a large individual investor, it is painful to achieve a 30% growth rate if Uncle Sam takes 40% off the top and reduces the growth to 18%. Unfortunately, this penalty is often ignored in the calculations of total return. Investors are beginning to appreciate this simple fact and are now understanding that growth can often be best achieved by letting the compounding take place and accepting the volatility that usually occurs. For years Intel was a wild speculative $4 stock before it became one of America’s greatest growth stocks.

Q: On the phone, you mentioned that you did not like the way managers are rated for their portfolio risk. What were your concerns?

A: The most important measure of a manager’s success is total return to investors. Measures such as Beta, Sharpe Ratio and Jensen Alpha do not contribute to making more money for our clients. Buying stocks at a reasonable price, allowing time, compounding and superior management to take their course does benefit our investors. I do not accept the rating of a manager as inferior when his actual long-term results are clearly superior. This flies in the face of history. Repeating, I remember a time when Avon products fell about 75% after some 20 years of stability and growth; another year when Intel started a multi-year growth of 2000% after years of formative volatility. Could anyone really give the Avon holding manager credits while penalizing the holder of Intel?

Q: Your strategy calls for analyzing global economic indicators. How does the state of the global economy influence your investment decisions?

A: Global economic indicators are increasingly important but the methodology of studying all of these factors is particularly difficult. Just recently we saw Russia melt down and lose something like $20 billion of newly ingested funds in a period of a few weeks. Japanese problems have now been ongoing for nine years, and no solution seems to be readily at hand. Accordingly, foreign investing has been very risky, and even wildly speculative in many countries. We certainly are watching with unusual care the global economic distress which has been developing worldwide. We have been seeking to lighten our investments in stocks with significant international risk, and, at the same time, to increase our exposure in the domestic area. We also believe that the current global trauma has a favorable effect on investment trends as interest rates decline and people seek out American dollars, bonds and growth stocks as places to invest which are significantly superior to every other area in the world.

Q: Most of the domestic market’s growth has come from newer industries such as computers, the Internet, biotech and high-tech communications. Do you invest in any of these sectors, and how do you evaluate them?

A: We are not confident that most of the market’s wealth has come from the newer industries you mention. The ethical drug area and consumer goods are continuing to roar onward, and stocks such as Coca-Cola, Gillette, Walmart, Merck and others in the various areas have been hugely successful. We have, however, invested in the computer industry in a major way. We hold very large amounts of Intel, Microsoft, Cisco and a few others. These stocks were bought in the early 1990’s when valuations were much lower. Our technology stocks probably average about 25% of the total of the accounts of the older clients.We have followed biotech stocks over the years and have on occasion owned Amgen and others for a period of years. We have not really had room in our investment accounts for many other new industries in that we were well satisfied with the growth that was being achieved by our current holdings.

Q: You keep your winners for the long-term. When is a stock considered a winner compared to other stocks?

A: We do not keep winners forever. We keep growth stocks as long as the company is growing well and the price is within reason. We do, however, have a discipline that constantly looks at the growth premium that exists for the Mercedes stocks over the Chevrolet stocks. In my 40 plus years the one time that I recall as being unusually dangerous was in 1972 when the growth stocks were selling at 50 times earnings in a 15 times earnings stock market. This meant that the premium was 200%, which was not justified. These stocks were ravaged in the years 1972 — 1974, even though earnings did not suffer. For example, IBM fell approximately 50% in a brief period, and stocks such as Xerox, Polaroid, Avon Products and others crashed and burned.The situation in recent years has been that the growth stock premium has been relatively modest and stocks such as Johnson and Johnson is only about 20% or 30% above the market multiple. Higher premiums have been awarded to faster growing companies such as Microsoft with good reason.

Q: You appear to have delivered consistently high returns over the years. How have you achieved your consistency?

A: We have been fairly consistent over the past ten years, but we have had “resting” periods. For example, we ranked first in the country in one study for five years ended 1991, but in 1992 and 1993 the growth stock market which we had emphasized was subjected to major reappraisal and our accounts were eroded moderately. We consider this to be a fairly natural development in that our accounts had approximately tripled in the five or six years ended 1991. The declines of ’92 and ’93 were in the area of 10% to 15% per year and reflected pullbacks in stocks like Merck. Merck had a cost of about $6 per share for our older accounts and when it reached $56 at the end of 1991, it was really stretching its price capability. In 1992-93 the stock fell to a low of $26 a share. We had the difficult choice in our taxable accounts of paying a large capital gains tax or waiting out the revival of the stock. Today the stock is selling over $130 and has basically more than quintupled in the last five years. So you can see with this example that clients must have the understanding, the fortitude and the patience to wait out this kind of a situation.We do change our thematic approach on occasion, and perhaps that has helped us achieve consistency over the years. If we perceive any real decay in the outlook for any of our four principal areas, we will take action that is both prudent and sensible.

Q: What are your current research sources, and how have they changed since your early days as an investor?

A: Our research sources are extensive. We see most of Wall Street’s research; we go to seminars given by brokers and by companies; we pay clear attention to trends in corporate affairs. We are particularly interested in annual reports and statements by management that are now accessible over the Internet and through conference calls. These sources are obviously radically changed from those of the 1950’s when there was little research available.We appear to pay more attention to investor psychology and patterns of buying and selling than most of the managers of whom we are aware. For example, we closely follow the Federal Reserve data to see where investment flows are going and how they change for the nation. For example, the latest figures as of the end of June show about $37 trillion of financial assets in the United States, of which about $16 trillion is invested in common stocks. This suggests that about $21 trillion is in interest rate money. We believe that trends such as this, augmented by other patterns and even daily odd-lot transaction results, can help us to see the kinds of risks and liquidity patterns that exist in both the domestic and global economy.

Q: Have your investment methods been influenced by the increased flow of investment information with its short-term focus?

A: Our investment methods have been little influenced by the increased flow of investment information with its short-term focus. We try to focus on the one-percent of available investment information that is critical to our industries and our companies. We insist on marching to our own drummer and are not concerned with very modest changes in the short-term outlook. In the past few years our goal has been to increase client stock values by 50% over a three-year period, believing that interest rates and inflation will be favorable. This implies roughly a 15% growth rate for our companies. If interest rates were skyrocketing and inflation was rising as well, we would have a much more conservative point of view and long-term growth target.

Q: You sell when you see ominous signs of a price decline. Are you talking about reducing exposure to the overall market, or do you sell on a stocky-by-stock basis?

A: Do we sell when we see ominous signs of a price decline? Well, that depends on the price decline. We are not trying to run in between the raindrops. In 1990 when Kuwait was invaded in early August, the Dow Jones fell approximately 20% in the next three months. We used late 1990 as an accumulation period and took massive positions in growth stocks that we believed would benefit from the coming one-sided victory over Iraq. Accordingly, we did not try to sell beforehand and buy back later. One would have had very little chance to buy again after the January 1991 invasion when growth stocks roared ahead. Our stock accounts were up over 80% in 1991.Regarding your question about reducing exposure, we believe that managers and brokers who adjust their stock allocation by three or four percent or even ten percent are making changes that have virtually no impact on performance. If we see risks developing towards the 1972 level, we are prepared to make massive actions to safeguard our clients. We think we have a capability to take this type of powerful action which is quite unique: managers of $50 Billion to $300 Billion or more are unable to execute huge cutbacks because of their size, and most smaller managers do not have the stomach for cuts big enough to be significant.

Q: Other reasons for selling include loss of price or earnings momentum. What factors are used as warning signs of loss of momentum?

A: We use common sense in looking at the loss of price or earnings momentum. Price momentum is not something we will jump on since we are perfectly willing to sit for two or three years on a stock as the background changes, earnings proceed, and the stock continues to have a bright outlook for resumption of price gains. We are looking to make an average of perhaps 15% per year, but market patterns are erratic and consolidating patterns are necessary.

Q: How did you decide to become a money manager?

A: I always wanted to become a money manager. It is something like my military career as a lead navigator for bomber formations. It is a huge challenge, which carries a vital responsibility. Success requires daily decisions based on very uncertain and rapidly changeable information. It is a fascinating, never-ending challenge.

Q: Who are some of the key people in your firm and what are their functions?

A: All of the people in our firm are key. Susan Brewer and Carol Ross are investment managers with strong backgrounds in investment management, finance and technology. They are each portfolio managers and analysts and are fully involved in our joint efforts. Our traders are uniquely qualified, experienced people. Barbara Fletcher, who is in charge of this area, has been with our organization for about 20 years. Diane LaBarbera, who is an officer of our firm, is uniquely capable and has been with us for over 30 years as an expert on accounting and many other company matters. Other key people include Peggy Althoff, Marcelle Nickerson, Joann Dunn and Pam MacMannis, all of whom keep our office running with remarkable efficiency. We can forward valuations to our clients at the end of each quarter or the end of each month within two or three days after the end of the month. Our accuracy rate is exemplary.

Q: What is unique about Cheswick in what it offers to its clients?

A: We do not think of ourselves as totally unique, but we do follow an investment style that is unusual. Most managers today are short-term oriented and have little quality standards or regard for capital gains taxes or lifetime targets. We seek to attract clients who understand the investment process and have the patience and fortitude to achieve outstanding results. We provide a distinct interest in each client’s circumstances and try to make each comfortable with the policy which is agreed upon and which may include far more cash and bonds for some clients than for others. We believe we provide a quality service and are determined to maintain our results over the years ahead.